Beijing can't afford to rein in the shadow financing system

Amid structural changes and political necessity, most new lending takes place underground but the market’s sheer size may be a problem

Tom Holland

BIO

As the writer of the South China Morning Post’s Monitor column, Tom Holland attempts each day to make sense of the latest developments in business, finance and economic affairs in Hong Kong and mainland China.

According to mainland media reports, Beijing has set this year's quota for new bank loans at nine trillion yuan (HK$11.11 trillion).

Now, nine trillion yuan sounds like a lot of money. Certainly it's more than the 8.2 trillion yuan in new local currency loans Chinese banks made last year.

But in relative terms, it's much the same. Last year's new loan total of 8.2 trillion yuan was 15.8 per cent of the mainland's gross domestic product. Assuming real economic growth this year of 8 per cent and economy-wide inflation of 2 per cent, this year's lending target will also be 15.8 per cent of GDP.

On the surface this makes it look as if the authorities have determined to curb rampant credit growth, which in 2009 saw new bank loans hit almost 30 per cent of the country's GDP.

But the structure of mainland financial markets has changed in the intervening years. These days much new lending takes place away from the banking sector's balance sheet via a shadow financial system of wealth management products and company-to-company loans, while the corporate bond market has exploded.

In many ways this is an encouraging development. Unlike bank deposits, high-yielding wealth management products allow investors to earn a positive real return on their savings. At the same time the shadow system permits private companies with no access to bank loans to obtain credit, albeit at high interest rates.

That should be good news for consumer spending, private sector development, employment, and overall economic growth and rebalancing.

But there are problems. The sheer size of the shadow market is one of them. In December, for example, the combined amount of trust company loans and company-to-company "entrusted" loans exceeded the total amount of regular on-balance-sheet loans extended by the formal banking system.

Ratings agency Fitch reckons that the nominal value of outstanding wealth management products has now climbed to some 25 per cent of China's GDP.

This ballooning in unregulated shadow financing has meant that despite the central government's tighter quotas for bank loans, the total amount of credit in China's economy has continued to expand, reaching almost 180 per cent of GDP last year, according to Vincent Chan and Peggy Chan at Credit Suisse (see the first chart).

"Instead of deleveraging after the massive credit surge in 2009, China re-leveraged to stabilise the economy," they note, warning that, "many countries have showed that such a rapid rise in credit usually results in financial instability."

Similar worries have prompted some observers to suggest that the authorities are preparing to rein in shadow financing this year.

But a major clampdown looks unlikely. In the past, leadership transitions in China have always been accompanied by investment booms as the new generation of Party bosses have sought to cement their power bases (see the second chart).

This time will be no different. State infrastructure investment has leaped over recent months, climbing more than 20 per cent year on year and driving the mainland's economic recovery from last year's slowdown.

Most of this infrastructure investment is being driven by local governments. And with a collective 2011 budget deficit of four trillion yuan, worth 8.5 per cent of China's GDP, local governments are heavily reliant on the shadow financial system, especially wealth management products structured by trust companies, to raise financing for their pet projects.

So although the authorities may well make cautionary noises, the political necessity of maintaining growth through the leadership transition will ensure that the shadow market continues to boom, even if that does threaten China's financial stability over the longer term.